Chinese President Hu Jintao’s visit to Washington brought renewed focus on China’s currency. It was likely the largest point of discussion between President Obama and President Hu. I suspect a less public, but related, issue was China looking for some certainty that America would make good on its obligations; after all, China is our largest lender.

What is often missed is the connection between these two issues: currency and debt. When China receives dollars for the many goods it sells us, instead of recycling those dollars into the purchase of US goods, it uses that money mostly to buy US Treasuries and Agencies (Fannie/​Freddie securities). These large Treasury/​Agency purchases (foreign holdings of GSE debt are over $1 trillion) have the effect of increasing the demand for dollars and depressing that for yuan, resulting in an appreciation of the dollar relative to the yuan. This connection exposes the hypocrisy of President Obama’s complaints about China currency manipulation — without massive US budget deficits, China would not be able to manipulate its currency to the extent it does. If the US wants to end that manipulation, it can do so by simply reducing the outstanding supply of Treasuries and Agency debt.

Another solution, which would also do much to end the “implicit guarantees” of Fannie Mae and Freddie Mac, is to take Fannie and Freddie into a receivership, stop the US taxpayer from having to cover their losses, and shift those losses to junior creditors, which include the Chinese Central Bank. Were the Chinese to actually suffer credit losses on their GSE debt, they would quickly start to reduce their holdings of such. They might also cut back on Treasury holdings. These actions would force the yuan to appreciate relative to the dollar. And best of all, it would end the bottomless pit that Fannie and Freddie have become. It is worth remembering that even today, under statute, the Federal government does not back the debt of Fannie and Freddie. It is about time we also teach the Chinese a lesson about the rule of law, by actually following it ourselves.

Of course this would increase the borrowing costs for Agencies (and maybe Treasuries), but then if China were to free float its currency, that would also reduce the demand for Treasuries/​Agencies with a resulting increase in borrowing costs. We cannot have it both ways.